It was three and a half weeks ago (May 14) that I wrote a post “Inflation Expectations Are Falling; Run for Cover” in which I called attention to the fact that inflation expectations, which had been rising since early in 2012, had begun to fall, and that the shift had coincided with falling stock prices. I included in that post the chart below showing the close correlation between inflation expectations (approximated by the breakeven TIPS spread on 10-year constant-maturity Treasuries and 10-year constant-maturity TIPS).
Then I noted in two posts (May 24 and May 30) that since early in May, I had detected an anomaly in the usual close correlation between short-term and long-term real interest rates, longer-term real interest rates having fallen more sharply than shorter-term real interest rates since the start of May. That was shown in the chart below.
I thought it would now be useful to look at my chart from May 14 with the additional observations from the past three weeks included. The new version of the May 14 chart is shown below.
What does it teach us? There still seems to be a correlation between inflation expectations and stock prices, but it is not as close as it was until three weeks ago. I confirmed this by computing the correlation coefficient between inflation expectations and the S&P 500 from January 3 to May 14. The correlation was .9. Since May 14, the correlation is only .4. That is a relatively weak correlation, but one should note that there are other three-week periods between January 3 and May 14 in which the correlation between inflation expectations and stock prices is even lower than .4. Still, one can’t exclude the possibility that the last three weeks involve some change in circumstances that has altered the relationship between inflation expectations and stock prices. The chart below plots the movement in inflation expectations and stock prices for just the last three weeks.
One other point bears mentioning: the sharp increase in stock prices yesterday was accompanied by increases in nominal and real interest rates, for all durations. That is not an anomalous result; it has been the typical relationship since the early stages of the Little Depression. Expected inflation implies increased nominal rates and increased borrowing costs. Moreover, expected inflation has generally been positively correlated with real interest rates, expectations of increased inflation being correlated with expectation of increased real returns on investment. So the conventional textbook theory that loose monetary policy increases stock prices and economic activity by reducing borrowing costs is simply not reflected in the data since the start of the Little Depression.